Seeking new capital to fund growth? You might consider going public through an initial public offering (IPO).
As we discussed last month (see “Stepping up to the selling block,” October), the decision to sell is primarily driven by a need for liquidity and wealth planning. The IPO, on the other hand, is primarily designed to bring in fresh equity to fund growth, and to establish a relatively liquid and efficient market for the company’s shares.
The IPO option is generally best for companies that are either large (sales of $400 million to $500 million-plus) or that have rapid growth (more than 10% to 15% annual growth). Public companies that don’t meet the size or growth criteria will typically not attract sufficient trading volumes and interest to maintain strong or consistent valuations.
An IPO provides limited cash for selling shareholders — it can take years for a business owner to sell his or her shares (secondary shares) after the initial public offering. Only limited secondary shares are typically sold in an IPO.
Why? Because it’s difficult to convince passive public shareholders to fund a company where management appears to be cashing out and perhaps losing their focus on the company. Here are some other considerations if you’re contemplating an IPO.
MAXIMIZING VALUATION: An IPO is structured to provide attractive business valuations by virtue of the highly liquid ownership vehicle. But public stock valuations vary over time, and given the long period of time from an IPO to total liquidity for the owner or seller, there is considerable valuation risk.
For example, an IPO at a currently attractive price per share may not sustain that high price years later for subsequent follow-on secondary offerings. This valuation risk is larger for smaller companies, because there are fewer shares outstanding, lower trading volumes, and less institutional interest in the investment.
An example of a small company IPO is that of Red Envelope, a $100 million direct marketer. Red Envelope went public at $14 per share in 2003, but traded for less than $10 per share since mid-2006, and eventually declined in value to zero in 2008 after its bankruptcy.
Going public did not achieve predictable wealth diversification and risk management for Red Envelope’s founding shareholders. That’s because of the required delay in providing liquidity and exposing the shareholders to business risk.
MANAGEMENT SUCCESSION: In an IPO, public shareholders are relying on existing management to run the company. They do not expect near-term management succession. So an IPO is not the proper vehicle for a CEO/owner looking to structure a near-term exit from the business.
CONTROL: Corporate control shifts from the owner/operator to a formal board of directors that has a fiduciary duty to protect the interests of all shareholders. The management team typically has a strong voice on the board, and usually has broad latitude in running day-to-day affairs.
CHARACTER OF A PUBLIC COMPANY: Public companies today are subject to rigorous regulation designed to protect the public from fraudulent practices and reporting, including the reporting requirements of Sarbanes Oxley legislation. Regulatory compliance is expensive and more easily borne by larger companies.
Furthermore, public stockholders focus on current quarterly financial performance, driving stock values up and down like a roller coaster. There is tremendous pressure not to disappoint public shareholders, creating an often unhealthy focus on short-term results to the detriment of long-term objectives.
As a result, most private companies should consider a private equity capital raise instead of an IPO if they require new funds to grow their companies. But as always, your ultimate goals will help you determine which transaction is right for you.
David J. Solomon is co-CEO of Lazard Middle Market (www.lazardmm.com), a subsidiary of financial advisory firm Lazard Ltd.